Controls on Capital Part of the Policy Mix, Says IMF Staff

Controls on inflows of foreign capital can one tool in broad policy toolkit

Countries should take account of impact of controls on other countries

With the global economy recovering, capital is flowing back to emerging market economies—a welcome development, according to IMF staff, in that it provides additional financing for productive investment, opportunities for risk diversification, and scope for consumption smoothing.

But some countries facing sudden and temporary spikes in different forms of foreign capital flows are worried about the possible problems this can cause for economic management or the health of the financial system.

Controls on foreign capital into emerging economies can be part of the policy options available to governments to counter the potential negative economic and financial effects of sudden surges in capital, the IMF staff said.

In a new Staff Position Paper “Capital Inflows: The Role of Controls,” issued on February 19, IMF staff discusses the circumstances under which controls on capital inflows to emerging market economies can usefully form part of the policy toolkit to address the economic or financial concerns surrounding sudden surges in capital. The paper is part of work under way by the staff of the 186-member international institution that reassesses the macroeconomic and financial policy framework in the wake of the devastating global financial crisis.

Controls part of a policy package

There are a number of policy choices governments can make when faced with a short-term or sudden surge in foreign capital, IMF staff said. These include

• Allowing the currency to appreciate

• Accumulating more reserves

• Changing fiscal and monetary policy

• Strengthening rules to prevent excessive risk in the financial system, and

• Capital controls.

In some circumstances, capital controls may complement the use of economic or prudential remedies to more effectively address the problem.

“There may be circumstances in which capital controls are a legitimate component of the policy response to surges in capital inflows,” the paper says, while noting controls would normally be temporary, as a means to counter surges. In particular, the paper notes: “If the economy is operating near potential, if the level of reserves is adequate, if the exchange rate is not undervalued, and if the flows are likely to be transitory, then use of capital controls is justified as one element of the policy toolkit to manage inflows.”

Nevertheless, evidence to date on the relative effectiveness of capital controls is ambiguous, according to the paper. Controls appear to work better in countries with existing restrictions, or with strong administrative capacity. Evidence also suggests that controls have more effect on the composition of capital flows than on their volume.

Not all capital inflows created equal

The analysis found that certain types of capital inflows can make a country more vulnerable to financial crisis. One example is debt versus equity flows, in which the latter allows for greater risk-sharing between creditor and borrower.

Capital inflows might also fuel domestic lending booms, according to IMF staff, which is especially dangerous if extended to unhedged borrowers, such as households, rather than to exporters.

Drawing on evidence from the recent global financial crisis, the paper also found that countries with larger initial stocks of debt liabilities and higher foreign direct investment in the financial sector fared worse in the crisis.

This is because both are linked to credit booms and foreign-exchange lending by the domestic banking system inside the country, which can make the financial sector more vulnerable, the paper said. IMF staff also found evidence that controls on capital inflows that were in place before the crisis helped improve growth resilience during this crisis.

Global effects of controls

Any country’s policies to control the inflow of capital will need to take into account the global effect, particularly as economies recover and countries look for new sources of growth, IMF staff said.

Controls would be inappropriate in cases where the exchange rate was undervalued from a multilateral perspectivesince this could frustrate needed rebalancing of global demand and the sources of growth in individual countries, and could redirect capital to countries less able to absorb it.

Controls should also not become a substitute for more fundamental—but perhaps more difficult—policy changes, as this could lead to adverse effects that could undercut the longer-term benefits from financial integration and globalization.

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